U.S Recession Tales Part 2

Here is Part 1 if you missed it.

This is Part 2 where I will narrate the tale of U.S fixed income, credit indicators and how they lead the economy. Needless to say, I constantly have to remind myself to keep this as short and succinct as possible else I might as well write a book. Again, if you are unfamiliar with some of the terms and causation of these indicators, feel free to Google and do further research. It took me many hours of study, research and market tracking to understand the implications on top of studying for my CFA. To those who messaged me asking when will my subsequent articles be posted, please be patient. Likely, it will be once a month. I spend my nights monitoring and trading U.S markets so I am only left with whatever limited time I have on the weekends along with other meaningful pursuits. Yes, life is just not about trading or financial markets.

 

THE MACRO-SENSITIVE INSTRUMENT

To sum it up, bonds are like the ending of a novel where you jump to if you want to know what will happen. If you had seen or read “The Big Short” or “Hedge Fund Trading Wizards”, you would have known that the U.S market was already in trouble when houses prices stagnated, money markets faced a liquidity crunch and credit spreads widened in 2006 despite the indices rallying to new highs. In short (pun intended), troubles will start brewing in the bond markets a year in advance or so before participants start realizing they are on the wrong side of the market. This is the time where the smart money sells to the suckers that buy in to the complacence and euphoria.

Just to be clear, I do not enjoy writing theories because if this predicament was true, the richest persons would be phD holders and Nobel Prize winners. Money is in the application of knowledge, the practicality behind the theory. For example, if the yield curve inverts, you can start buying short term treasuries and sell the back end of the curve for a good risk/reward trade. Most of the drop will be on the front end so even if you’re wrong, at least the back end of the curve will rise about as much as the front end. If bonds are not your cup of tea, lighten up on your equity positions and hold cash. Even doing nothing is doing something. Take Kevin Daly for example, as a long-only portfolio manager featured in Jack Schwager’s Trading Wizards, has a cumulative gross return of 800% despite experiencing the dot com and subprime crash as he knew when to go to cash. Or you could even wait for the subsequent decline in interest rates after the inversion and then look for long juicy entry points in bonds. Forex or Currency Trader? USD/JPY or Yen Futures is waiting for you. Read Part 1 if you’re wondering why. If you prefer to stick to the indices, you could even time short entries, say on the SPY, by using bond/credit spreads as an entry indicator. Also, did you notice that the energy sector usually rallies near the market top with money flow into consumer staples? If you insist on investing/trading in bonds in the present environment, floating-rate bonds maybe a good bet. You’re limited by your own creativity (and knowledge).

 

LEADING MARKET INDICATORS

We will begin with the Fed Fund Rate vs 10 year Treasury Yield spread as the FFR is akin to  a remote control that the Fed uses to manipulate the economy.

[Images are all taken from www.fred.stlouis.org except when indicated]

The 10 year yields are climbing but dropped slightly to 2.8% while the FFR stays within the 1.75 – 2.00% range. For now, there is still more room for rate hikes but Jerome Powell and co will have to be careful on how soon would they want to normalize rates. Markets will tend to race towards the top as the spread narrows when the bond traders feel that the 10 year yields would not have further room to climb as corporate earnings and balance sheets start to deteriorate at the expense of rising inflation. At this point of time, investors will start demanding a higher premium for holding instruments hence widening the credit spreads. As the Fed starts getting more hawkish on their stance, the curve inverts this tightens liquidity as it would not be profitable for banks to lend out money – they would simply lose from the spread. This situation can be frightening as there will soon be a flight to safety, causing further liquidity problems. This self-fulfilling prophecy would accelerate a market decline.

[Image taken from Stockcharts.com]

 

The yield curve on the left looks flatter than ever and it’s a matter of time when the inversion happens. The back end of the curve fell more rapidly (16 basis points) with deceleration towards the front end which held steady when compared from the last 3 weeks. It is of no surprise that the financials have not been doing too well this year with a decline of 5.5% YTD which is a close second worst performer behind staples. I would keep a good watch on commodities as it is often a good leading indicator of inflation and if inflation gets out of hand, this may force the Fed to aggressively hike which would already make a less desirable situation worse.

Above is the spread between the 10 year Treasuries and 3 months bills. The two critical yields are 1.0% and 0%. The first trouble would be indicated by the spread dipping below 1.0% and then confirmed when the spread stays negative for around 2 months. Yes, this is akin to a yield curve inversion if the 3 month bills would yield more than the 10 year. This is just a different perspective of viewing the yield curve.

The top chart shows different corporate-grade bonds of similar maturities while below shows the spread comparison between junk bonds and higher quality investment grade bonds. The junk spread indicated by the red line is still staying below the critical 5% level while the investment grade debt securities has risen slightly in this year’s vexatious performance but still remain below the end of 2015 yields. Earnings have been decent with more than 70% of the S&P500 companies beating their EPS and revenue estimates but soon this will be tested as earnings season begins in two weeks. The lowest class among all investment grade bonds – the “BBB” rating is still below the dreaded 2% yield level albeit spreads on the whole are rising in tandem with market volatility this year. These bonds are faced with various risks such as interest rates, inflation, default risk, liquidity and prepayment risk hence the premium demanded by investors vary based on macroeconomic situations.

The increase in premium can be due to a certain risk which is not associated with recessions, for example prepayment and liquidity risk which causes yield fluctuations in a economic growth scenario. Most importantly is to discern default risk from the spread where the BBB-AAA spread would be a better indicator in this case since what differentiates the two bonds of similar maturity would be the creditworthiness of the debtor. Both have similar callability provisions. Note that spreads have reduced to lows due to technology, retirement demand and pension contributions. On the other hand, the AAA-Treasury spread  shows more of the prepayment and liquidity premium as Treasuries are the safest and most liquid debt instrument. Finally, the AAA-Junk spread is more representative of both default and liquidity risk since junk bonds are generally more illiquid and poses a higher risk of default. Hence, it is vital to look deeper into individual spreads to draw a more accurate conclusion.

 

CREDIT INDICATORS

One of the reasons why I follow the financial sector closely is because financials are the heart of the economy. Money makes the world and market go round. Banks are the rivers that channels liquidity from the Fed to the streets. Companies who need money seek financial institutions. Without leverage, growth would be slow. The key is economies of scale. Apply this to productivity and nations would prosper.

Having said that, loan growth and business credit conditions are key drivers to the economy. There is a positive correlation between capital expenditure and credit conditions where easier credit conditions encourages capital spending. Thus, if credit conditions are good, economy will be strong.

The graph above shows the financial conditions in money market, debt and equity markets while the graph below shows the tightening standards for loans ranging from commercial, industrial for large, mid and small firms, consumer loans, credit cards and auto loans. As for the Chicago Fed Adjusted National Financial Conditions Index chart, the lines depict coincident indicators of financial activity which are sometimes used to forecast GDP two to four quarters ahead. The blue line is the adjusted weighted average of 105 indicators of risk, credit and leverage which are expressed relative to its sample average and scaled by a standard deviation. Level of 0 means the financial system is operating at a historical average levels of risk, credit and leverage consistent with economic activity and inflation. Positive values indicate that financial conditions are tighter on average while negative values indicate the opposite. The red line is the nonfinancial leverage subindex where positive values indicate increasingly tighter financial conditions associated with rising risk premiums and declining asset values. What happens is that the net worth of households and nonfinancial firms reduce and leads to deleveraging and hence lower economic activity. To lump these up, leverage is the leading indicator to financial stress (coincident with risk) which then leads credit measures taken by the financial institutions (tightening in this case for example).

We can see from the top chart that as financial conditions get tighter where all 3 lines are positive, it has to stay above 0 for at least 3 months before a recession hits. In current times, we can see that credit conditions are still relatively loose but further rate hikes could jeopardize this scenario. We can also see leverage and the ANFCI increasing currently which indicates that although general conditions remain loose, it is still relatively tightening. In addition, tightening standards are painting a picture where consumer loans, credit cards and auto loans are tighter than usual as compared to looser standards for corporate loans. This analysis is in line with the current yield curve scenario where spreads are tightening which squeezes the profit margins for banks. As a financial institution, I would rather lend my money to those who invest the funds into growth or investment scenarios with adequate collateral which pose a lower risk of defaulting as compared with consumers who indulge in depreciative spending in credit cards, personal or auto loans. I cannot afford a higher default risk when my margin is already squeezed as my profits would stem from the ability of my clients to pay up the capital alongside the interests. However, it could also be due to increasing demand in consumer loans or high debt service ratio of households that make lending them money less attractive. My guess is also that earnings performance plays a part on whether the balance sheet and cash flow of companies look more attractive and “loan-friendly”.

 

IN A NUTSHELL…….

Having looked at all data, it would be safe to say that cracks are already starting to show in this bull market in terms of the yield curve. Although generally the absolute numbers do not look threatening in derailing the current bull market just yet, the relative trend is showing deterioration in credit spreads albeit not at an alarming rate. Hence, the overall sentiment is mildly bullish as of now from the bonds and credit spread data. Q3 and midterm election year seasonality and self-fulfilling prophecies along with the Trump indicator is keeping this market volatile as earnings season is approaching. I would watch the commodities space closely as well for signs of oncoming inflation. In the bond space, the keen investor would be on a lookout for floating-rate bonds which tend to perform the best among all bond classes in this rate hike environment.

Over and out,

Ramone

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